Mike Price sends: With Netflix’s (NFLX) recent run-up I decided to take a look at it using the rules from The Warren Buffett Way.

Business
Simple, and Understandable
They have an inventory of a crapload of movies and they rent them out to people on monthly plans.

Using this model they don’t have to pay huge capital expenditures to grow - by building brick-and-mortar stores - just to acquire subscribers.

Consistent History
Very consistent, even though they were attacked by Blockbuster twice they still have managed to grow subscribers.

With Blockbuster paying more attention to their margins and less to spending non-stop to create growth, Netflix should be able to return to its more consistent past.

Favorable Long-Term Prospects?
Very. Netflix is on the cutting edge of Internet VOD.

They currently have more than 8,000 movies available to watch on demand. This feature is limitless and well worth the price of subscribing - especially for young people like me who may be in college and using their computer constantly.

Any battle over video formatting also benefits Netflix, because it adds more time to the disc rental market.

Netflix was the first-mover in Online DVD rental, and is currently the best at VOD, I wouldn’t be surprised if they start a straight to the TV type rental service soon, even if they don’t soon it will still bring huge growth.

Management
Rational
I really like Netflix management. They’ve showed their ability by destroying Wal-Mart and Amazon’s attempt and by fighting off Blockbuster.

I also like their shrewdness in not entering the economically unsound video game rental business.

Candid
They did well on their Conference Call, and I liked how they talked about each different competitor and how they have reacted.

Resists the Institutional Imperative
Their press release always read ” Netflix release xquarter results,” and they did not seemed focused on the short term in the Conference Call.

Financials
Return on Equity
ROE is currently 16%, pretty good, but I expect it to increase in the future.

Owner’s Earnings
Income $66,952
+ D&A $224,962
- CapEx $223,436.00

= Owner’s Earnings $68,478.00

Profit Margins
Netflix has about a 9% margin which is constricted from Blockbuster; it should raise in the future.

Valuation
DCF
Using Owner’s Earnings, a 10% discount rate, growth starting at 18% next year than falling from there and then adding excess capital I get a value of $28 per share.

Multiple Moats
-Netflix has a network effect. Each movie has reviews from multiple users on it and Netflix shows you what percent your likes and dislikes correlate with that user. This is a tremendous help in picking movies and is exponentially better than what any competitor could start with because of its millions of users.
-Netflix has a great rating system where one can rate each movie they rent from 1 to 5 stars, Netflix then uses this to guess how you might rank other movies, in my experience and that of many people I’ve talked to it is never more than one star off. This is a great lead to finding movies and its algorithms are a lot better than Blockbuster’s (I’ve used both).
-The Netflix user is not usually one who keeps the service based on its cheap price; rather the Netflix quality.

Some differences I’ve noticed with Netflix and Blockbuster Total Access include:
-The quantity of movies. Netflix just has a lot more movies than Blockbuster. It has over 70,000 titles from which to choose, this is a huge advantage for finding users that love movies that may not be available anywhere except Netflix.
-The quickness. If I wanted to I could receive a movie in the mail on Monday around noon, then have it in the mail by 3, so it would get mailed that day, on Tuesday I would get an e-mail saying they received the movie and they were sending the next on my queue. With Blockbuster there were usually three or four days in between.
-As before stated the network effect and ratings system is a huge advantage, for people that really like movies this community is great and I have seen a lot of reviewers with hundreds of reviews that love to show they could be a critic, they never leave Netflix based on price because this community is likely not available
-And customer service, I haven’t dealt with either, but Netflix has been mentioned in numerous surveys as having among the best in the industry.

Finally, proof of Netflix’s moat has been shown when Wal-Mart (WMT) spent a bunch of money trying to create its own Internet rental service, but just lost even more money and ended up selling its customers to Netflix. The result of this was Amazon (AMZN) killing any thought it had of a movie rental business.

Also, Blockbuster (BBI) has spent hundreds of millions of dollars in an attempt to break into the mail delivery industry, pricing their plans lower than Netflix’s and offering free movies at brick-and-mortar locations - they effectively leveraged their brick-and-mortar business in their vain attempt, no doubt killing a lot of margin - and still have just one-third of Netflix’s market share, at a margin much lower than Netflix.

Conclusion
Netflix looks overvalued right now, but I remain confident in their abilities. The problem with Netflix, currently, is in no way its moat or business - it the valuation. I will consider selling part or all of my position and hoping to buy again soon if someone else comes into the picture and Wall Street pushes the price down again. However, I will not sell until I find a better company than Netflix in which to invest my money.

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